Why a Balloon Mortgage is the Sasquatch of Loans

The balloon mortgage is the Sasquatch of loans – something you hear about but may never see. They really do exist, though, even in today’s more conservative mortgage market.

IngDirect (Stock Quote: ING), for example, offers a five-year Easy Orange balloon mortgage that carries a fixed rate of 4.25 % for the first 60 months. After that, the entire loan balance is due in an enormous “balloon” payment.

IngDirect sweetens the deal by offering the option of renewing the loan at that point at the lowest rate the firm then offers on its standard mortgages. That new rate would last for another five years, after which the loan balance would be due in full. IngDirect requires a 25 % down payment on these loans.

The appeal, of course, is the low rate for the initial period. The average 30-year fixed mortgage charges about 5.6%, according to the BankingMyWay.com survey. Five-year adjustable-rate mortgages average 4.9 %.

Since the lower rate on the balloon produces a lower payment, it may be easier to qualify for the loan. Or the lower rate could make you eligible for a larger loan. Use the Maximum Mortgage Calculator to see how much you could get.

Many mortgage shoppers confuse the balloon deal with the ARM. In an ARM, the starting rate is fixed for the initial period and then automatically adjusts up or down according to a formula, but the loan balance is not due at that point.

With both loans, the borrower risks a substantial increase in payments if interest rates are higher after the initial period. The balloon mortgage carries an additional risk: because of a lost job or other financial problem, the borrower could have trouble qualifying for new loan when the balloon comes due.

Also, the balloon borrower may face substantial closing costs on a new loan, while the ARM borrower would not. If rates were to skyrocket, the balloon borrower could have an enormous payment increase with the replacement loan. The ARM borrower would face a payment increase as well, but ARMs typically have a lifetime cap on interest-rate hikes, often six percentage points above the starting rate.

These dangers have to be considered alongside the benefits. Payments on ING Direct’s balloon loan are figured as if the interest rate were fixed for 30 years. At 4.25%, payments would be $492 for every $100,000 borrowed, and a balloon payment of $91,300 would be due after five years.

The 30-year fixed loan at 5.56% would charge $572 a month. So the balloon loan would save the borrower $4,800 per $100,000 over five years. On a $300,000 loan, that would be $14,400, a significant sum.

On the other hand, no one knows what rates will be in five years. The odds are they will be higher than they are now, since they are at near-historic lows. If so, you might regret getting a balloon loan rather than locking in a low rate with today’s fixed mortgages.

The balloon loan is best, therefore, for borrowers who won’t need a mortgage after five years. Perhaps you expect to sell and move in that period, or you’re betting on a windfall like an inheritance that could be used to pay the balloon.

In normal times, home buyers can be fairly confident of selling for enough after five years to pay off their mortgages. These aren’t normal times, and many people are stuck with homes that are worth less than they’d paid a few years ago, and less than they still owe their lenders.

Now that housing prices have fallen in so much of the country, the question is whether they will rebound. The market is showing signs of improvement, but that’s no guarantee that a home bought today will sell for more than is owed in five years. If it won’t, you could end up with a balloon payment you cannot meet, either because you cannot sell the house or cannot qualify for a new loan that’s large enough.